Convertible bonds are a somewhat rare but interesting asset type. Here we’ll explore what they are, how to buy them using the best convertible bond ETFs, and why you might (not) want them.
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What Are Convertible Bonds?
As the name suggests, convertible bonds are corporate bonds issued by companies that are able to be converted to shares of common stock. Convertible bonds are a hybrid security in that sense – providing the predictable interest payments of a bond but also allowing the bondholder to convert to shares of stock.
Convertible bonds have stock and bond characteristics, in that they’re affected by both interest rate changes and changes in the company’s share price. As such, on average, expect convertible bonds to rise less in stock bull markets and fall less in stock bear markets.
The resulting number of shares of stock at conversion is predetermined by what’s called the conversion ratio. For example, a 10:1 ratio means one bond would convert to 10 shares of stock. Similarly, the conversion price is the price per share at which the bond(s) can be converted to shares.
With a plain vanilla convertible bond, if the share price decreases, the investor would likely simply hold the bond to maturity, at which time it would return its par value, plus the interest payments along the way. If the share price increases, the investor may have an incentive to convert the bond to shares of common stock if the estimated gain is greater than the interest received from remaining payments if the bond is held to maturity. After conversion, the investor can hold or sell the shares of common stock.
A mandatory convertible bond requires the investor to convert the bond at a specific ratio and price. A reversible convertible bond gives the power to the issuer, allowing them to force a conversion or keep the bond as a fixed income instrument until maturity at their discretion.
A little over $100 billion in convertible bonds were issued in 2020. Don’t get too excited, though; most are sold privately to institutional investors and are not available to retail investors. This is also still only about 2% of the total outstanding corporate bonds.
How To Buy Convertible Bonds
Institutional investors can buy convertible bonds privately. If you’re reading this, you’re probably not an institutional investor, so you’re relegated to convertible bond ETFs and mutual funds, which should be preferable anyway, to diversify the credit risk, liquidity risk, and default risk of the issuers. Below are 3 of the most popular funds.
The 3 Best Convertible Bonds ETFs
There are only a handful of convertible bonds ETFs available, and only 3 of them have appreciable AUM.
CWB – SPDR Barclays Capital Convertible Bond ETF
The SPDR Barclays Capital Convertible Bond ETF (CWB) is the most popular fund in this space, with over $6 billion in assets. The fund provides exposure to a cap-weighted index (the Bloomberg Barclays U.S. Convertible Liquid Bond Index) of U.S. convertibles, regardless of credit quality. The fund also holds convertible preferred stock.
Top 10 holdings include Tesla, Wells Fargo, Southwest Airlines, Snap, and Bank of America. This fund has 270 holdings and an expense ratio of 0.40%.
ICVT – iShares Convertible Bond ETF
The iShares Convertible Bond ETF (ICVT) costs precisely half of CWB with a fee of 0.20%. It has about $1.5 billion in assets and seeks to track the Bloomberg Barclays U.S. Convertible Cash Pay Bond > $250MM Index.
Unlike CWB, ICVT screens out mandatory, preferred, and zero coupon convertibles. Short-term traders will appreciate the comparatively greater liquidity of CWB. ICVT has slightly outperformed CWB historically.
FCVT – First Trust SSI Strategic Convertible Securities ETF
FCVT is an actively managed convertible securities ETF from First Trust. This fund has no geographical restrictions, so First Trust can opt to include convertibles around the globe outside the U.S. Investors may choose FCVT if they believe the convertibles market is inefficient and has opportunities to arbitrage some alpha.
Managers of FCVT attempt to identify convertibles they believe are of higher value and have more favorable risk/reward characteristics. This active management comes at a hefty cost; this fund’s fee is 0.95%.
But Should You Buy Convertible Bonds? Probably Not.
Issuing convertible bonds allows companies to avoid the negative sentiment from investors from issuing equity shares that would dilute the shares outstanding. This also provides some downside protection for the investor if the company fails, with the potential upside from the conversion opportunity if the company thrives. Because of this inherent conversion value, convertible bonds typically have lower returns and lower coupon payments. This attribute is good for the issuer, allowing the company to issue debt at lower interest rates than traditional bonds, but hurts the investor. Remember that most convertible bonds are callable, and are typically called at a time that is advantageous for the issuer and not the investor. Basically, the investor gets the worst of both worlds.
Convertible bonds may be a sensible vehicle for investors to get exposure to volatile companies they’re uncertain about, but they are only as good as the credit of the issuer, requiring extra due diligence from the investor. In certain instances, the issuance of convertible bonds can be a sign of a company with an uncertain future, as their credit rating may be too poor to be able to issue traditional bonds. This lines up with the fact that many convertibles are issued by small cap growth stocks, the worst performing segment of the market historically. In the event of bankruptcy, higher-ranking debts will also be paid before convertible bond holders.
Investors may also simply prefer to hold junk bonds for a higher yield. With convertibles, you’re basically buying equity risk plus high-yield corporate bond risk, but in a less efficient, less straightforward, costlier way than holding each of those separately. I’d also rather utilize Emerging Markets government bonds as a way to access credit risk without the associated high correlation to equities.
Vanguard closed and liquidated their own $1 billion convertible bond fund in early 2019, citing that investors can achieve the same risk exposure by holding stocks and traditional bonds. The fund also never took off with its institutional target audience. Stocks and bonds can be hard enough to understand. Convertibles add another layer of complexity that investors may shy away from, and that complexity typically favors the creator of the vehicle, the issuer, and the big guys. Warren Buffett advises not to invest in something you don’t understand.
Larry Swedroe also submits, in his book The Only Guide to Alternative Investments You’ll Ever Need, that this shifting behavior of convertibles also makes it impossible to determine an appropriate asset allocation that includes them in a diversified portfolio with stocks and traditional bonds, if there even is one. Asset location is another issue here. We know stocks are good for taxable accounts and bonds are less tax-efficient and are thus usually best held in tax-advantaged space. Since convertible bonds are a hybrid, they have no place to naturally call home.
In summary, retail investors are probably wise to avoid convertible bonds altogether. If you want more equity risk, buy more equities. If you want less equity risk, buy more nonconvertible bonds.
Where To Buy These Convertible Bond ETFs
If you do want to buy a convertible bond ETF, the ones listed above should be available at any major broker. My choice is M1 Finance. The broker has zero trade commissions and zero account fees, and offers fractional shares, dynamic rebalancing, and a modern, user-friendly interface and mobile app. I wrote a comprehensive review of M1 Finance here.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.